The Sage Group plc (LON:SGE) stock has put in a decent performance: do financials matter?

Sage Group (LON:SGE) shares are up 4.9% over the past month. Since stock prices are typically aligned with a company’s financial performance over the long term, we decided to investigate whether the company’s decent financials played a role in the recent price action. In this article, we have chosen to focus on Sage Group‘s ROE.

Return on equity, or ROE, is a test of how effectively a company is increasing its value and managing investors’ money. In short, ROE shows the profit each dollar generates in relation to its shareholders’ investments.

Check out our latest analysis for the Sage Group

How is ROE calculated?

The return on equity can be calculated using the following formula:

Return on Equity = Net Income (from continuing operations) ÷ Equity

So, based on the formula above, the ROE for Sage Group is:

24% = £291m ÷ £1.2bn (based on trailing 12 months to March 2022).

“Yield” refers to a company’s profits over the last year. So this means that for every £1 of investment by its shareholders, the company makes £0.24 of profit.

What does ROE have to do with earnings growth?

So far we’ve learned that ROE measures how efficiently a company generates its profits. Based on how much of its profits the company chooses to reinvest, or “retain,” we are then able to assess a company’s future ability to generate profits. Assuming all else being equal, companies that demonstrate both higher return on equity and higher earnings retention tend to be those that exhibit a higher growth rate than companies that do not share the same characteristics.

A head-to-head comparison of Sage Group’s earnings growth and 24% ROE

First off, Sage Group has a pretty high ROE, which is interesting. Second, the company’s ROE itself is quite impressive compared to the industry average of 8.8%. For some reason, however, the higher yields aren’t reflected in Sage Group’s meager five-year net income growth averaging 2.4%. That’s interesting, as the high yields should mean the company is capable of generating high growth, but for some reason it hasn’t been able to. We believe that low growth with fairly high yields could be the result of certain circumstances such as poor earnings retention or poor capital allocation.

As a next step, we compared Sage Group’s net income growth to that of the industry and were disappointed to find that the company’s growth was below the industry average of 12% growth over the same period.

Much of the basis for increasing the value of a company is tied to its earnings growth. The investor should try to determine whether expected growth or earnings decline, whichever is the case, is being priced in. This then helps him determine whether the stock is placed for a bright or bleak future. Is SBU valued fairly? This company intrinsic value infographic has everything you need to know.

Does Sage Group use its retained earnings effectively?

The high three-year median payout ratio of 64% (meaning the company only retains 36% of its earnings) over the past three years for Sage Group suggests that the company’s earnings growth has been slower due to paying out much of its earnings.

Additionally, Sage Group has paid dividends for at least a decade, meaning the company’s management is committed to paying dividends even if it translates into little to no earnings growth. Based on the latest analyst estimates, we have found that the company’s future payout ratio is expected to remain steady at 56% for the next three years. As a result, Sage Group’s ROE is also not expected to change significantly, which we derived from the analyst’s estimate of 23% for future ROE.

Conclusion

Overall, it looks like Sage Group has some positives in its business. However, we are disappointed that despite a high ROE, there is no earnings growth. Keep in mind that the company reinvests a small portion of its profits, meaning investors aren’t benefiting from the high rate of return. Against this background, the latest analyst forecasts show that the company will continue to increase its profits. To learn more about the latest analyst forecasts for the company, check out this visualization of analyst forecasts for the company.

Do you have any feedback about this article? Concerned about the content? Get in touch directly with us. Alternatively, send an email to the editorial team (at) simplywallst.com.

This Simply Wall St article is of a general nature. We provide comments based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.